Soon after succeeding his brother at the helm of Indian construction group Lanco, L Madhusudhan Rao spotted an opportunity that looked too good to miss.

India’s 2003 Electricity Act was a landmark in the liberalising reform drive that began a decade before, turbocharging the coal-fired power sector by abolishing a burdensome licensing regime.

Mr Rao’s Lanco was quick to take advantage. Over the next few years, it borrowed heavily to set up a string of power plants scattered across the nation.

Lanco was far from alone. Dozens of companies, from obscure local businesses to giants such as the Tata and Adani conglomerates, rushed to wager what seemed a one-way bet, with electricity demand set to soar in India’s accelerating economy.

Today, however, the power sector is at the heart of a wave of corporate defaults that threatens to cripple the country’s financial sector. Lanco is already being dealt with under India’s tough new bankruptcy system, and Credit Suisse forecasts that as many as 40 other power companies could follow, with the sector accounting for at least Rs1.8tn ($26bn) of non-performing loans. This raises the prospect of heavy writedowns threatening the major banks’ already strained balance sheets.

“There was a mad rush, and huge investments went in that did not make sense,” said Abhishek Poddar, a partner at management consultancy AT Kearney. “What we’re seeing right now is the outcome.”

It may seem paradoxical that Indian power producers are unable to stay in business when millions of citizens are crying out for electricity — even after the government's recent announcement that all 600,000 Indian villages are now technically connected to the grid.

The explanation lies in part with the chronically dysfunctional power distribution system, controlled mainly by state governments. Regional leaders have frequently resorted to offering power at unsustainably cheap prices to win votes, said Pratik Agarwal, chief executive of Sterlite Power, one of the large transmission companies that links power producers and distributors.

This has pushed many of the state-owned distribution companies into dire financial straits, leaving them unable to meet their dues to the power producers — let alone sign more purchase agreements. “They’ve been making a loss on every unit they’re selling,” said Abhishek Tyagi, an analyst at rating agency Moody’s. “So they’ve been restricting their losses by not buying additional power.”

A government drive to move the distribution companies’ debt on to the state governments’ books helped cut their losses, but they still owed Rs262bn in unpaid dues to power producers at the end of March.

“If your business goes under because you have not run it well or have taken risks that backfired, that is one thing,” said Arunabha Ghosh, chief executive of New Delhi’s Council on Energy, Environment and Water. “But it is different from if you have a cash flow problem because your buyer is not paying up.”

Even as the power producers have been struggling to collect money from customers, they have also had trouble procuring the coal that fuels their plants. State-controlled Coal India, by far the country’s biggest producer of the mineral, has failed to meet ambitious production targets. Several power producers sought to mine their own coal, only to have their licences cancelled in 2014 by the Supreme Court, which said they were issued on unduly easy terms.

The latest blow to the coal-based producers has come from renewable energy providers, which have seized on technological advances to offer power at ever lower prices — aggressive behaviour that looked “a bit similar” to that of their coal-based peers a decade earlier, Mr Poddar said.

This accumulation of factors resulted in a wave of financial distress among power companies, which accounted for about 40 per cent of newly recognised bad corporate loans in the first quarter of this year, according to Ashish Gupta, India research head for Credit Suisse.

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They now find themselves in the line of fire of one of the country’s most important recent reforms: a bankruptcy code introduced in 2016 that mandated liquidation of insolvent companies if no buyer could be found within 270 days.

Banks had been reluctant to force power companies into this process, fearing hefty writedowns and expecting that demand would recover after a few years as addressable demand picked up, said Credit Suisse’s Mr Gupta.

But in February the central bank intervened to give them no choice, ordering lenders to launch an insolvency process if a default situation was not resolved within 180 days.

A first wave of big insolvency cases in the steel sector has triggered a tussle among big players to snap up smaller rivals, but no similar dynamic is expected in the power sector, where even major groups such as Adani Power and Tata Power are under financial strain.

“I don’t expect many people to evince a lot of interest — or they’ll show interest at very low prices,” Mr Poddar said.

This month a court ordered a temporary moratorium on new insolvency cases for power companies, in what some in the sector hope could be a prelude to a broader exception being granted for a strategically vital industry, particularly given that much of its distress resulted from problems at state-run customers.

In the worst-case scenario, warned analysts at Bank of America Merrill Lynch, plants accounting for up to 17 per cent of national power capacity may end up being scrapped, a worrying prospect ahead of a huge expected increase in electricity demand.

“If Indian growth is back on track, then there’s every reason for every plant in the country to be operating,” Mr Agarwal said.